Captive Guideposts for 2009

The year 2009 has already had baked into it some significant changes which will impact captive owners, and there will likely be a few more as the year unfolds. I will supply some guideposts and cautions in the hope that it will be of some help.

Diligence and prudence must be the watch words for captive owners in the
coming year, more than perhaps in any previous year.

Optional Federal Charter (OFC)

The past few years have seen many discussions about the federal government
getting into insurance regulation. The most discussed option was for an Optional
Federal Charter to be created under which an insurer could elect to be regulated
as currently, on a state-by-state basis, or choose to be regulated by the federal
government. The argument in favor of this proposal is that state-by-state regulation
is too slow and cumbersome for an insurer with multiple state and international
exposures. There is much evidence to support this argument.

It can take an inordinate amount of time to process applications for rate
changes, policy wording changes, new coverage approvals, and many other daily
facets of life at an insurance company. Such delays can not only slow the process
of gaining needed acceptance, but also introduce competitors such as alternative
structures for risk finance. This costs insurers revenues and jobs.

This discussion is now moot other than for the many upcoming hearings on
how the federal government will regulate. By injecting money into AIG, Hartford,
and others, the federal government is now at the table and will demand, rightly,
a significant say so in how the insurers operate.

How the Feds will regulate is a very significant question and to my knowledge
no one has the answers at this time. Also, how captives will be treated is an
open discussion. Few people inside the federal government have the obvious credentials
to either be singled out to act as a new czar of insurance regulation, or to
step up and propose a mechanism. But it is certain that there will be such a
mechanism. No one, especially Congress, will inject $150 billion+ into purchasing
79.9 percent of the shares of AIG without demanding to know how the money will
be spent.

Gaining such knowledge will introduce the ability to affect how the money
is spent. Now that Hartford (and perhaps others) has purchased a
bank in order to receive funds, it will be subjected to banking regulations.
How will the bank regulators view insurance and captives? The state regulators,
who perhaps have much to lose in this process, will be putting forth many arguments
to support their positions, such as knowledge, in-place processes, experienced
staff, and a history of good work. But they have not invested monetarily. That
will trump their arguments, especially when placed in the light of the perceived
failure of the recent and current regulatory structures.

AIG

AIG has arguably been the most important insurer for captives for decades.
In addition to being the largest U.S. property casualty insurer, it is easily
the dominant fronting partner and reinsurer. While many of its clients may complain
about collateral treatment and claims adjusting and reserve calculations, the
AIG companies have always been at the forefront of the captive industry. That
will change, but no one can predict how.

It is certain that if a captive decides to change insurers, getting collateral
relief from the new owners, who likely will have no knowledge of the past process,
will be very difficult. If the Feds have your letter of credit (LOC), what is
the argument for returning it, substituting it, or even reducing it?

The breadth and depth of AIG’s staff in captives and alternative risk is
impressive. How many will stay to work for the federal government? Their share
holdings are probably gone or severely reduced in value. Their bonus programs
are likely scrapped. What does the career path hold for the future with Uncle
Sam as the new boss and much of the company for sale?

Any significant movement of experienced staff will bring unpleasant changes
to captive owners. Certainly there will be a temptation to follow good people
to new homes, but will the new homes have the management and resources to handle
the new business as well as it was done at AIG? And don’t forget that you may
not be able to take your collateral with you when you move—nor obtain many favorable
reserve adjustments for your claims.

Offshore Reinsurers

Legislation of varying nuances has been introduced many times over the past
decade to address the perceived "immoral" advantage seemingly gained by U.S.
insurers with offshore reinsurers or offshore ownership. Much of this is fomented
by a few U.S. insurers against a few Bermuda insurers, and in the past has been
successfully buried by sound arguments and the realities of the political landscape.

After January 20, 2009, the landscape changes. President Elect Obama has
publicly criticized such arrangements as being tax avoidance schemes which should
not be tolerated. Legislation is being drawn and the battle will commence early
in his administration. Expect the Internal Revenue Service (IRS) hawks at Treasury
to be eager to join the fight.

While it is expected that arguments against changing the offshore reinsurance
practices drastically will be vigorously mounted, I would foresee that the fight
will be hard in a new climate of distrust of financial structures that are not
well understood by the public and the public’s representatives. There is a real
danger of an anti-financial globalization wave of new legislation and regulation
which will have a wide and deep impact on captives. Domiciles with substantial
and significant captive practices will be thoroughly examined by people with
negative attitudes.

Hardening Markets

In 2008 many captives sought collateral relief in the reinsurance markets.
This is a good short-term tactic, but it could endanger the longer term strategy
of enhanced risk finance independence. Reinsurers are open about the need for
rate increases for the midyear renewals, if not before. They have suffered record
natural hazard losses, coupled with, for many, record investment losses. This
situation will be addressed in the classic manner: substantial rate increases.

Will this affect captives directly? No one is proposing anything new for
captives at this time. But we are entering the Age of Unintended Consequences.
When legislation is drawn and proposed for insurers, it will take a high alert
system for captive owners to fight to not be included in the legislation, or
to be treated fairly and not alongside insurers whose profile is so different
from the captive.

The opportunities for captives in a potentially unsettled market are great.
Captives can provide many needed solutions not only to private industry but
also to public industries such as healthcare. Captives are generally nimble
and quick, well financed, and well managed.

Most captives have available associations which can advance their interests
if their parent company cannot carry the fight. This would be a good year to
challenge captive associations to stay up to date on proposed changes and to
be prepared to come to the aid of their members. It is a good time to be comfortable
with your captive manager and advisers, confident that they are paying attention
and will offer helpful advice.

The opportunity is great—as are the challenges—if one is prepared.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

Like This Article?

IRMI Update

Dive into thought-provoking industry commentary every other week,
including links to free articles from industry experts. Discover practical
risk management tips, insight on important case law and be the first to
receive important news regarding IRMI products and events.